2009-04-04T08_16_38

Trillions of Dollars Lost in Financial Meltdown:
and Who Has the Money...

These days all too frequently we hear that billions of dollars
have been lost in the latest financial downturn. While such
frightening headlines lead to attentive viewers and readers, it is
worthwhile thinking through their details.

Keep in mind that markets represent equilibrium situations, the
balance between what sellers will accept for a commodity and what
buyers are prepared to spend for that commodity.

In a normal market, if you try to instantaneously realize a
substantial fraction of the value of the commodity traded in that
market, you will disturb the equilibrium, which will affect prices
and that effect will generally be dramatic.

For example, consider a quiet town and its property market. One
percent of the houses in that town might be for sale on any given
day, and let's assume there is a balance between buyers and
sellers. (We will ignore the fact that property prices are rather
strongly influenced by interest rates, instead we'll assume that
the primary determinant of house prices is whether buyers and
sellers can agree on a price). Happily, because house prices are
stable in this town, it is possible to determine the approximate
value of any home, by comparing with recent sales of similar
properties.

It is even possible to put a value on the property of the entire
town. You simply multiply the numbers of houses in the town by
average home values, and obtain the town's total property
value.

If average property prices come down by 10 percent, for example,
the local media will write headlines which read 'Billions Lost in
Property Slump', using numbers which assume that the total property
value can be obtained by valuing houses at the peak in comparison
with current values. Such headlines will insure that home owners
are worried enough to watch the ensuing set of commercials, or buy
the evening paper, but do not imply that this amount of money has
actually been lost.

This is because the 'value' of property in this market could
never be deposited in a bank as a result of selling all the
properties in the town simultaneously.

As soon as there were, say, twice as many houses in the town on
the market at the same time, prices would drop. The same number of
buyers would suddenly find twice as many properties to choose from,
make lower offers, and realtors would start to encourage owners to
price their houses 'to move', and banks would reduce the amounts
that they were prepared to lend. Average prices would then fall,
probably significantly, in response to the relatively small change
from 1 to 2 percent in the number of houses on the market.

If the number of sellers were ever to get to 100 percent, the
price of property in this town could go to zero.

So, the total value of a market is never going to be extractable
and we should not think that if average prices move down that huge
sums of money have been lost. Proclaiming that a reduction in home
prices has led to a loss of billions is a vast over simplification.
Despite the fluctuations in house prices, at no point in
proceedings do houses disappear from the town. The people continue
to have their homes and despite the unease created by the change in
prices, most people are not materially affected, and most
importantly no money actually vanishes from the system. All the
money which moves from buyer to seller exists before and after the
change in house prices. A small number of people may have assets
which cannot be immediately completely liquidated by sales, and a
small number of people have made profits on their sales of houses
bought when the market was lower, but the vast majority of people
in the town do not lose money.

This perspective can be applied to stock markets too. The
favored headline will be 'Billions Wiped Off Stocks'. However, just
as for property in the small town, it is impossible for the value
of the stock market to be liquidated and deposited in a bank, and
we should not pretend that this is possible in order to create, or
respond to, scary headlines.

What can remove money from the market are the fees associated
with transactions. The commissions paid to realtors, stock brokers,
and bankers are lost to the financial market, and impose a drag on
the system. Hence, it is interesting to note that an enthusiasm to
create transaction churn often precedes a crash. The packaging and
repackaging of securities and large commissions associated with the
sales of those securities, pulls large amounts of money from the
market, and undermines market efficiency. The commissions become so
large that they are simply added to the purchase prices but they
are not returned to the markets when sales occurs. Indeed, such
commissions lead to the transfer of substantial market value to
realtors, stock brokers, and bankers. Headlines on these subjects
tend to be relatively rare, although these are the real market
losses. And, as the immense personal fortunes of Wall Street
executives demonstrate, this aspect of capitalism can be remarkably
efficient.

As much of the financial 'get-well' legislation is written from
the perspective of commissioned market practitioners, rather than
individual property owners and investors, it is quite likely that
this weakness will continue to be built into the financial
system.

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